What is Market Making?

This article will explain how market-making works. It will also explore the important role Kamino plays as an automated and optimized “proxy” to DeFi market making.

What is Market Making?
What is market making?

Most experienced users in the decentralized finance (DeFi) community are familiar with the automated market maker (AMM). You deposit tokens into a liquidity pool, and the AMM helps facilitate trading on a decentralized exchange (DEX) by using your tokens.

Becoming a liquidity provider (LP) is a streamlined process in DeFi that takes a few clicks of a button. However, the process has been so streamlined for years that the most seasoned DeFi degen might still ask:

“What, exactly, is market making after all?”

“What the heck is market making?”

This article will explain how market-making works. It will also explore the important role Kamino plays as an automated and optimized “proxy” to DeFi market making for users and projects that rely on Solana’s concentrated liquidity DEXs for trading tokens.

TradFi Market Making 101

Market makers play an important role in traditional finance (TradFi). Primarily, they help keep markets liquid and trades flowing by consistently buying and selling assets. By establishing an equilibrium of buys and sells, market makers reduce price volatility and make it easier for other traders to execute trades.

Trading Anything That Moves

The difference between market makers and other market participants lies in the market maker’s willingness to buy and sell everything that comes their way. Market makers are traders too, but they are uber traders working with industrial-sized volumes at the highest frequencies possible.

A retail trader might acquire an asset to hold it for a long time until it appreciates in value, but market makers are trying to sell as quickly as they buy. They’re the shoe store trying to turn inventory as fast as possible, not the guy keeping a sealed-in-the-box pair of Air Jordans for his great-great-great grandson to have appraised on an episode of Antiques Roadshow in 200 years.

Market makers are like a store turning inventory as fast as possible.

Making Money from Market Making

A market maker’s bottom line depends on the bid-ask spread, or the price they are willing to pay for an asset and the price for which they are willing to sell an asset. If market makers are buying assets they know they can quickly sell, the spread between their buy price and sell price is less than it would be for taking the risk of buying something that “dies on the shelf.”  

Market makers try and buy and sell assets as quickly as possible.

Market makers rely on volume to earn an edge, and they can earn healthy profits from collecting the tiniest spread between thousands of bids and asks. In TradFi markets today, market making is mostly computerized to increase efficiency and squeeze as much value as possible from a competitive field of tight spreads.

The Effects of Market Making

For other market participants, the effects of market making are huge. The difference between buying on a market with market makers and buying on one without is like the difference between haggling down a $20 tube of toothpaste on the street and walking into a convenience store with realistic prices clearly marked on the shelves.    

Illiquid markets provide inefficient prices.

Market makers make assets readily available and easy to trade. With a market maker present, traders can always find a counterparty willing to buy or sell an asset at an acceptable market price, and the convenience of trading assets in a capital-efficient and liquid market encourages economic activity.

How AMMs Brought Market Making to DeFi—Rather Inefficiently

Market makers are the quintessential middlemen of trading markets. However, DeFi has a knack for cutting out middlemen, so a way to automate market makers had to be figured out before DeFi DEXs could operate in earnest.

The early days of DeFi trading on Ethereum were an example of an illiquid market that suffered from a lack of market making. Without market makers present, predictions markets, instead of exchanges, thrived on-chain with spreads as high as 10%.

Birth of the Automated Market Maker (AMM)

As a solution, the AMM was an idea first proposed by Vitalik Buterin in a Reddit post about how to operate a DEX on-chain. The idea is simple: add equal values of Token A and Token B into a liquidity pool, and then Token A can be deposited into the pool in exchange for taking out an equal value of Token B.

Vitalik Buterin deliberating the concept of an AMM.

The AMM isn’t the market maker by itself, though. What it does is automatically adjusts the spread between the bid and ask price according to the supply of each token, and then it controls the inflow and outflow of tokens accordingly.

The other parts of the AMM market-making equation are LPs. These are users who deposit their tokens into a liquidity pool in return for earning fees when their tokens help facilitate trading.

Liquidity providers provide the tokens necessary for decentralized trading.

Instead of earning profits from the spread between a bid and ask, LPs earn fees from traders for the right to use their tokens in a swap. A wider spread for more volatile and lower volume assets is represented by an adjustment in fees that can be as low as 0.01% for stable pairs and as high as 3% for highly volatile assets.

Problems with Capital Efficiency

The problem with this kind of AMM is that it supplies tokens for trading across an infinite price range. This means that an extraordinary number of tokens are necessary to make sure trades will not significantly experience a wider spread between the bid and ask as they are executed.

It also means that the vast majority of an LP’s tokens will not be used for trading and, therefore, will not earn the LP fees as their tokens remain dormant in a pool.

Much of the liquidity provided on an AMM is held away from traders.

Market makers earn their bread and butter by trying to buy and sell as much of their inventory as possible and as quickly as possible. Consequently, keeping inventory supplied at unrealistic price ranges hurts liquidity providers’ chances of making a profit while taking on the risk of holding volatile assets at the same time.

How CLMMs Changed the Game for Market Makers

The goal of a market maker is to buy and sell as much as possible to make a profit from the spread, however small the spread may be. When an LP’s assets facilitate swaps on a DEX, they can earn fees for the service, so concentrating liquidity around a current price point helps LPs earn more fees than if their tokens are spread out across an infinite price curve.

Concentrated Liquidity = Earning More Fees with Fewer Tokens

Concentrated liquidity market makers (CLMMs) can help LPs collect more fees from trades by allowing them to choose a price range where they would like to supply their liquidity. This means that LPs can deposit fewer tokens on a CLMM and earn similar fees to depositing exponentially more tokens on an AMM.

A smaller and capital-efficient deposit on a CLMM can earn LPs more fees.

LPs only collect fees when the current price of an asset falls within their set range. As a result, the width of this range can affect how much LPs are actively providing liquidity to traders. A tighter range can capture more fees around a current price point, but it also carries more risk for an LP, as there is a greater chance that the price moves outside of the LP’s range.

Users providing liquidity on a CLMM can only be market makers as long as the current price of an asset remains within their preset range. If a position falls out of range, then a user becomes a spectator who traded out of the market, no longer participating as a market maker.

In terms of market making, the low end of the range on a SOL-USDC CLMM position represents a bid, and if the price of SOL falls below the bid, then the user buys a 100% position in SOL.

A position falling out of range can buy SOL on the decline.

If the price rises above the ask, then the user ends up selling 100% into USDC.

Prices rising outside of a set range leave SOL behind. 

When a user ends up with 100% of one token, it’s called divergence loss. If a user wants to provide liquidity again, they have to rebalance their position by trading for the lost asset (paying fees instead of earning them) and resetting their range around the new price.

Otherwise, users can wait for prices to return to their original range to begin collecting fees again. While waiting, though, LPs are absorbing an opportunity cost that leaves unused capital on the table.

Waiting for a position to rebalance itself ignores other opportunities to earn yield.

A CLMM more closely reflects market making with an order book, but this doesn’t necessarily make the process any easier. There are many considerations to take into account when setting and managing liquidity positions on a CLMM, and successfully acting as a market maker on a concentrated liquidity DEX takes time, effort, and skill.

Kamino Automates Market Making for Users and CLMMs

Market making isn’t easy, and most market makers today rely on technology to boost their performance. Providing liquidity on a CLMM is definitely not the easiest form of market-making, but it’s getting easier with advances in market-making technology like Kamino.

Kamino Optimizes Ranges

A traditional market maker has to balance risk with reward when setting a spread. If the spread is not competitive, then other market makers will capture more trading volume; if the spread is too competitive, then a market maker risks losses due to volatility outpacing gains.

Concentrated liquidity positions are difficult to manage effectively.

CLMM liquidity providers face a similar difficulty when setting ranges and deciding when to rebalance their positions. Kamino solves these problems for LPs by acting as a “proxy” market maker that automates concentrated liquidity strategies based on advanced quantitative modeling.

Choosing Tokens to LP

By using Kamino, anyone can become a market maker without much knowledge about making markets. The major consideration for users who want to become market makers through Kamino is the risk profile and assets they’d like to expose themselves to:

  • Stablecoin strategies reduce the risk of divergence loss and exposure to market volatility, since only stablecoins are provided as liquidity. The fees, or the spread, earned for providing stablecoin liquidity can be as low as 0.1%.
  • Pegged-asset strategies reduce the risk of divergence loss, but they maintain exposure to the market, since the pegged assets move together in price, like stSOL-SOL. These strategies also earn 0.1% in fees.
  • Volatile asset strategies can earn higher fees, but they are also exposing the user to divergence loss and the volatility of the market.  

Since Kamino takes care of the heavy lifting in market making, balancing the risk of holding an asset as a market maker against the possible rewards of market making is the biggest challenge users face. Unfortunately, this isn’t something that Kamino can help users decide!

Market Making Takes a Technological Turn with Kamino Powered CLMMs

Kamino puts the pieces of the DeFi puzzle together.

Kamino is more than just an easy way to deposit tokens and earn yield. It’s like the glue that stitches together several important pieces of the DeFi puzzle to bring the benefits of market making to decentralized trading:

  • LPs benefit from the opportunity to passively participate in optimized and automated market-making strategies and earn yield from fees.
  • Traders benefit from easy access to tradeable assets 24/7 with the tightest bid-ask spread possible, since concentrated liquidity can negate price slippage.
  • Projects can easily achieve deep liquidity for their tokens.

Becoming a TradFi market maker is 100% impossible for the retail user. With the evolution of DeFi, it’s possible for anyone to become a market maker in markets that see millions of dollars worth of daily volume, and anyone can participate with however much capital they have available.

Kamino has been designed to make the process of participating in market-making activities, and yielding from these activities, easier than ever. As DeFi continues to open doors to the world of finance, Kamino is proud to help provide the keys to a better world of DeFi liquidity.